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Vanguard ETF Shares are not redeemable with the issuing Fund other than in Creation Unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

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Stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries.

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All investing is subject to risk, including possible loss of principal.

Every year about this time, I bask in the warm glow of schadenfreude as I read stories such as the Wall Street Journal’s “Why market forecasts are so bad.” (Subscription required.)

“On average, the analysts thought the S&P 500 would rise 8.2% in 2013,” writes reporter Joe Light. “The S&P 500 has actually risen 27.5% this year through Friday, not including dividends—a difference of 19.3 percentage points.” (The Journal article was published on December 20, 2013. By year-end, the index had produced a 12-month return of 32.4%, including dividends.)

How can highly trained experts with vast research resources at their disposal be so … wrong?

Although I chuckle at the forecasters’ foibles, it’s not really the forecasters who are wrong. It’s the belief that a one-year stock market forecast, whether from Warren Buffett or the proverbial shoeshine boy, can convey useful information.

My 2014 outlook

A good forecast includes both an expected value and a range of potential outcomes. The use of a range “treats the future with the humility it deserves,” as Vanguard Chief Economist Joe Davis likes to say. The size of this range depends on the variability of what you’re forecasting and the degree of confidence you demand in your forecast.

In the stock market, these inputs produce a range of outcomes that seems more like a cowardly dodge than a forecast, the work of an ignorant amateur. To say that the stock market could follow a number of wildly divergent paths simply sounds less authoritative than a bold and unequivocal forecast for, say, an 8% return.

Since 1926, the S&P 500 Index has produced, on average, one-year returns of 12%.* The range of those returns has been wide—a one-year low of –43% in 1931 and a one-year high of 54% in 1933. If we assume that these patterns can serve as a guide to the future, we can use the historical data to forecast a stock market return for 2014, confident that our forecast will capture 95% of the potential outcomes.

Ladies and gentlemen, here it is: In 2014, the S&P 500 Index will return between –27% and 51%.**

Instead, our economists and analysts produce 10-year forecasts, assigning probabilities to the different outcomes. Over longer periods, asset class returns become less volatile, allowing us to forecast a range of outcomes narrow enough to be useful in long-term asset allocation decisions.

Vanguard’s longer-term focus reinforces another lesson. Investing, particularly in the stock market, is a long-term undertaking, and one-year forecasts are the wrong tool for the task.

* The one-year average return is different from annualized compound returns, which are lower and more relevant for long-term financial planning.

Andy Clarke

Andy Clarke helps lead Vanguard's Corporate Communications department.
Before joining Vanguard in 1997, Andy worked at Morningstar as an investment analyst. He is the author of Wealth of Experience, an introduction to investing based on ordinary people's stories about what has—and hasn't—worked as they've tried to meet their investment goals.
Andy holds a B.A. in English from Haverford College and is a CFA charterholder.

Comments

David P. | February 4, 2014 2:29 pm

Noticing the current market volatility/negativity: I wonder if the the behavior of the market is affected by the fact that a lot of money is now in ETFs and part of the selling pitch for ETFs is that they are very quick and easy to trade/flip,more so than traditional mutual funds.
Does the popularity of ETFs increase market fluctuation?
Also of interest is whether market volatility is driven by money managers-such entities as pension funds and mutual funds more so or less so than by individual investors trading individual stocks,bonds,buying or selling mutual funds or ETFs?

Paul D. | February 1, 2014 10:40 am

Andy, I read with interest Mark Hurlbert’s Wall Street Journal article today, “What to Do When the January Indicator Says Sell”. Yet another good point about making predictions and forecasts with caution.

Even with all the references to previous years performances being tied to that of January’s performance, one still comes away with the standard caveat….past performance is no guarantee of future performance….and predicting the short term direction of the market is a fools errand.

Perhaps, using a 50+ year time span would tend to make the argument very convincing…..except, the exact reverse is equally as likely to happen over the next 50 years.

physguy272 | January 15, 2014 1:36 pm

It is important to remember that when reporting a confidence interval (95% chance that the return will be between -27% and 51%) that that is still a very crude estimate. The best way to convey this probability distribution is with… a probability distribution. That is, a full graph of the probability distribution. There are likely tails and outliers and the shape is likely non-Gaussian. I would be interested to see this for Vanguard funds. A figure of a pdf where one could select a given percentage. That is, what is the range within a 99.7%, 95%, 68%, 20%, etc. historically. I say this because they probably don’t scale linearly even for nicely averaged things like indices (indexes? what do you guys call them?) because they are often (in, say, a mutual fund) treated as a single object.

Physguy,
Thanks for your comment. You’re right. The distribution of stock market returns has not been Gaussian (normal). It’s negatively skewed, so there has been a somewhat higher probability of negative returns than a normal distribution would imply. While I hesitate to write something so imprecise to someone with the screen name Physguy272, I think that for most purposes, the normal distribution is “good enough” for communicating the range and likelihood of possible outcomes.
My colleague Fran Kinniry recently posted a similar blog with a histogram-like chart of one-year stock market returns. It’s clearly not Gaussian, but returns are more or less symmetrically distributed around the average, albeit with longer and fatter tails than we see in a normal distribution. Here’s the link to the blog post.

Gene V. | January 21, 2014 7:25 pm

I’m guessing physguy is, like me, a physicist. It amazes me how often physicists all-to-quickly assume Gaussian error distributions as well, particularly when propagating errors, and when errors are large or bounded. I’ve given up on hoping for as much from financial advisors, so I was pleasantly surprised to see some recognition of this here. Kudos.

Paul D. | January 15, 2014 11:03 am

I am LOL Andy, your tongue in cheek single year forecast of -27% and +51% is of course hilarious. A single year prognostication is what one would get from the many ‘expert’ stock pickers plying the field today. I always wondered why their crystal ball is so positive and accurate before they get your money but never so clear afterwards. Never hear much about their bad calls do we?

Precisely why I personally so value the 10 year charts that Vanguard includes in every fund analysis so I can make up my own mind. Everybody with an ounce of wisdom realizes that past performance is not an accurate indicator of future performance, so why does anyone put such faith in a single years forecast? That’s like forecasting the weather for next December….warm and sunny…with snow…maybe….or maybe not.

Paul,
Thanks for your comment. I like the weather analogy. But as my colleague Fran Kinniry noted in an earlier post, weather forecasters are practically clairvoyant compared with their stock market counterparts. Here’s a link to his blog post.
Thanks again!
Andy

Paul D. | January 30, 2014 11:12 am

Thanks for the link to the Vanguard Advisors Blog Andy. I did not previously know of it’s existence and have found a bounty of informative, useful and in-depth postings there. Particularly enjoyed Jim Rowley’s “Another babka, another duration” as well as Fran Kinniry’s “Dewey defeats Truman”….I actually remember that one when I was just a kid.

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Visit vanguard.com or contact your broker to obtain a Vanguard ETF or fund prospectus which contains investment objectives, risks, charges, expenses, and other information; read and consider carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in Creation Unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss in a declining market.

Stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries.

An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund.

All investing is subject to risk, including possible loss of principal.